Low Oil Prices Are No Longer Seen As Good For the Economy

After flirting with breaking below $30 per barrel, oil decidedly broke that threshold at the end of last week, deepening the unrelenting losses the market shave witnessed so far in 2016.

The reasons for the 20 percent decline in oil prices since the start of the year range from rapidly growing concerns over the Chinese economy, fears of a persistent glut in oil supplies, and most recently the removal of sanctions on Iran. Iran has vowed to bring back 500,000 to 1 million barrels per day (mb/d) in oil within a year. In fact, the Iranian oil ministry issued an order to increase production by 500,000 barrels per day immediately after sanctions were removed.

The gains in Iranian output could be frontloaded, since anything more than the 500,000 to 1 mb/d in increases will require significant investment and may take years to come to fruition.

Still, the near-term effect is negative for oil prices. Even though oil markets have largely baked in the effect of Iran bringing oil back online into the price for crude, there was a bit of a knee-jerk reaction to the news that sanctions were lifted. Also, Iran has oil and condensates sitting in floating storage in the Persian Gulf, inventories that will now be able to be sold off. Estimates vary, but Iran is believed to be sitting on 18 tankers full of 12 million barrels of crude oil plus 24 million barrels of condensates. As those volumes are sold into an oversupplied market, prices could suffer from further downward pressure.

The pessimism continues to weigh on the price for crude. Hedge funds pushed their net-short positions on the price of oil to record highs, an indication that oil speculators believe that oil prices will continue to decline. According to data from the Commodity Futures Trading Commission, net-short positions jumped by 15 percent to 200,975 futures contracts for the week ending on January 12, an all-time high. Similarly, net-long positions fell to five-year lows.

“There are a lot of people who thought oil can’t go down much further and tried to call a bottom,” said Michael Corcelli, chief investment officer of Miami-based hedge fund Alexander Alternative Capital LLC, told Bloomberg in a Jan. 17 interview. “When we have monster pullbacks, things don’t end politely. I think we’ll drop to $24 or $25 and then have a sharp V-shaped rally.”

While low energy prices are thought to provide a boost to the global economy as consumers benefit from lower costs, there are growing signs that the dramatic collapse in oil prices – so sudden and so severe – is actually creating economic headwinds. The oil and gas industry spent $200 billion on drilling, refining, and new equipment in 2013, and the sharp cutback in spending is being felt beyond just the oil patch. Last week Wood Mackenzie estimated that $380 billion worth of oil and gas projects were scrapped by the industry.

In the New York Times on Jan. 16, Paul Krugman explored the issue. Oil and gas companies start to have liquidity problems when oil prices crash by 70 percent in less than two years. The drop off in spending hurts broader industrial activity. Meanwhile, oil-producing countries like Saudi Arabia have to undertake painful austerity.

The effects show up in a variety of ways. A slowdown might be felt in demand for drilling-related materials such as engines, trucks, steel, and rail capacity. But the effects can also be financial. As the FT reports, big banks are feeling the pain. Citigroup reported a 32 percent increase in non-performing corporate loans in the fourth quarter, compared to the same period in 2014. Wells Fargo also reported an increase in charges, largely due to the decline in oil and gas. JP Morgan said it might have to add more money to its reserve base because of its deteriorating energy portfolio.

From a macro-economic perspective as well, crushing oil prices could be negative. The plunge in oil could affect interest rates, and not in the way that is typically thought. Low energy prices push down inflation – usually seen as a good thing – freeing up central banks to conduct expansionary monetary policy to stimulate the economy.

But such a sharp decline in oil prices is also forcing the massive sovereign wealth funds, much of which is backed by oil money, to pull out some of their funds from financial markets in order to address budget problems in their home countries.

Between April and September 2015, the NYT Editorial Board notes in a recent op-ed, sovereign wealth funds withdrew $100 billion from their investments, half of which came from Saudi Arabia’s fund. If even a small chunk of the $7.2 trillion in sovereign wealth fund assets is retracted because of energy stress, it could force up interest rates as bonds are sold off. At the same time, the plans emanating from Riyadh are notoriously opaque, so nobody really knows what to expect.

With oil showing no sign of rebounding in the near-term, the effects of the collapse only become more pronounced.